In the first phase, the central government only delegated implementation of economic policies to the provinces. Hanoi licensed investment and placed factories where it chose — initially around Ho Chi Minh City. As this southern region became a magnet for foreign direct investment (FDI) and experienced explosive economic growth, its leaders became bolder and pushed — and even overstepped — the boundaries of the law, in a process known as ‘fence breaking’. In the second phase, provinces attracted investment by improving regulatory environments. Investors then pushed for more, and taxes and jobs that came with FDI reinforced the positive feedback loop between investors and local regulators.

Successful provinces then transferred large fiscal surpluses to the central government. In 2004, only six of Vietnam’s then 64 provinces contributed to the central treasury. Moreover, demand for labour caused significant migration into those FDI-rich provinces. Hundreds of thousands of workers and their families began to depend on the industrial jobs in the ‘fence-breaking’ provinces.

Clearly, the central government could not crack down without killing the geese that laid the golden eggs.

This situation can be described as a harmony of interests, whereby all interest groups are better off cooperating than using coercion to gain a greater share of available rent. With the success of early reformers in shaping the business climate to the liking of a growing number of foreign investors, the central government turned from de-concentration to outright devolution of power. Many of the fences broken in the early reforms were mended not by a centre that re-imposed itself, but by one that re-wrote the laws, including granting the provinces the authority for economic management.

Now, Vietnam is entering a third phase of decentralisation. The new slogan is ‘too much competition, not enough coordination’. Every province lobbies for an airport, seaport or a new highway. But the problem is Vietnam’s particular fiscal allocation system. The central government negotiates the share of revenue a province is entitled to retain instead of sending it to Hanoi. The retention rate largely depends on what projects the province can convince the central government it needs to carry out. If the centre pays the bill, a province has no incentive to be thrifty or to coordinate with a neighbour over the optimal use of ports and industrial parks.

What is at issue here is thus not excessive competition among provinces with too much authority, but the violation of an iron principle of fiscal federalism: allocations must be formula-based, not open to negotiations and lobbying. Vietnam has largely decentralised economic authority, but it still coordinates resource allocation from the top. It is this gap between policy responsibility and fiscal self-determination that is causing problems with inefficient use of public funds.

But this third stage has a positive side as well. The most heavily invested provinces already argue that the high cost of living makes labour-intensive, low-value-added industries unviable. These provinces are partnering with surrounding — if less developed — provinces in what could be described as a domestic flying geese model, the policy of sending less productive industries to a poorer and cheaper location, while focusing one’s own efforts on higher-end processes and products.

The challenge for Vietnam’s central government is not to fall back to the old ways, when central officials declared that the party was right and any problems must have been the fault of misguided implementation at lower levels. The centre will have to give up some of the power that comes with distributing projects across the country to reward officials. Local officials will spend resources more wisely if they have to depend on a set amount of formula-based fiscal allocations whose use they then have to prioritise.

The East Asian model suggests that central guidance works best in the early stages of industrialisation. To make the move into a knowledge economy that vies for domestic value-added industries and avoids the middle income trap, the central government would be well advised to resist the temptation of reverting to coordination from Hanoi, and instead let the process of inter-provincial competition — which has worked so well in the early stages — run its course.

Thomas Jandl is a Scholar in Residence at the School of International Service at American University, Washington. His research focus is on Southeast Asian political economy.